CHICAGO – The Chicago Public Schools paid a punishing yield to close its private placement of short-term state grant anticipation notes Monday.

Market participants attributed the high rate to the credit challenges faced by both the school district and the state government.

The $275 million unrated transaction that matures March 31 will allow the junk-rated district to hobble through the fiscal year’s end on June 30 and meet its teachers’ pension payment obligations. An initial rate of 6.39% lasts until July 2, when it will be adjusted. The rate will be based on 70% of the London Interbank Offered Rate plus a spread of 550 basis points and it will be reset monthly.

“That's a lot of rate,” said Brian Battle, director of trading at Chicago-based Performance Trust Capital Partners, noting that the district issued long-term bonds under its general obligation credit last year at rates around 8%.

 Brian Battle, director of trading at Performance Trust Capital Partners
“That's a lot of rate,” said Brian Battle, director of trading at Chicago-based Performance Trust Capital Partners.

The grant anticipation note deal is the latest in a series of costly short-term financings CPS has made in recent years to stay afloat.

The rate on the district’s $1.55 billion of fiscal 2017 tax anticipation note financings, entered into between September and January, was based on 70% of LIBOR plus a 4% spread, so the district’s cost appears to have risen by about 1.5%. The 4% spread rises to a high of 6% should the district’s ratings fall from their current single-B levels to CCC-minus. About $950 million remains outstanding and matures in December.

Recent one-year note sales that carried top MIG1 or SP-1-plus ratings priced at below 1%.

“The lender is getting paid to make this loan,” Battle said. ”If someone else would have done it cheaper, CPS would have picked them."

JPMorgan was chosen from three bidders to enter into final negotiations to buy the notes, according to sources.

The district issued the notes because the state government, which has an unpaid bill backlog of more than $15 billion, is not making grant payments on time. The interest rate, Battle said, reflects the “severely injured” credits of both CPS and the state.

“Yes, the GAN tends to be very secure and it's usually a timing issue, with the calendar being fixed," he said. "Here contagion is proved in because we expect Illinois will pay.”

The state has until Dec. 31 to distribute the FY 2017 grants. Rating agencies have been watching closely for any signs that the school district is at risk of losing market access given its precarious liquidity.

“The spread differential is large enough to suggest that demand for the paper was keenly limited and CPS is fortunate to have had market access at all,” said Richard Ciccarone, president of Merritt Research Services.

“The numbers suggest that the market has serious concern that the combination of cash flow, state support and political stalemate could threaten timely debt service sooner or later,” he said. “The state's own prolonged political dysfunction compounds the matter and escalates the risk of contagion.”

Mayor Rahm Emanuel’s administration and CPS announced plans to leverage overdue state grants last month as the district warned it needed cash to keep schools open through their scheduled close Tuesday and meet their pension obligations.

The district blamed its fiscal year-end crisis on Gov. Bruce Rauner’s veto of $215 million in teachers’ pension help, a judge’s decision tossing the district's lawsuit accusing the state of discriminatory funding practices, and state block grant payment delays.

The district on Monday blamed Rauner for the costly borrowing.

“School districts throughout Illinois have suffered under the Rauner administration's failure to provide education funding in a timely manner, and the agreement CPS was forced to reach today is a direct result of this failure,” Ronald DeNard, the district’s senior vice president of finance, said in a statement.

Like several market participants, the district portrayed the state’s tardiness in meeting its obligations as a factor in the yield penalty.

Operating aid has been forwarded to schools in a timely fashion but the state is three quarters behind in distributing grants amid an impasse in Springfield that has left the state without a budget for almost two years. Borrowing documents report that CPS grant delays have risen to $467 million from $102 million a year ago.

The Rauner administration countered that the blame squarely lies with CPS and said it is state Comptroller Susana Mendoza who distributes the grant payments. The comptroller prioritizes operating aid, payroll, legal and consent decrees, pension payments, and debt service and has warned there’s little left over to meet remaining obligations.

“We are saddened that the Chicago Public School district is trading its future financial health for another short-term easy fix. It has no one to blame high interest rates on other than the decades of mismanagement that created this crisis,” said Rauner spokeswoman Eleni Demertzis. “The governor is hopeful that the General Assembly will spend the next week focused on passing a truly balanced budget that will help school children across our state, including those in CPS.”

Rauner has called a special session this week that continues through June 30. Various bills have passed with Democratic votes that would aid the district and a proposed GOP budget and reform package have offered the district new funding.

An education funding overhaul would provide another $300 million, but Rauner has called it too favorable to CPS. Proposed state pension changes include the $215 million in CPS teachers’ pension help.

The district has pressed its case for more operating aid because it serves a mostly minority, low-income student population without receiving the same pension help all other Illinois school districts receive. The Rauner team has countered that the district receives $250 million in special grants to offset the pension disparities.

CPS intends to borrow a total of $389 million of GANs, or 85% of the $467 million in overdue block grants. The district could only close on $275 million because it lacks the legal authority to leverage the remaining amount until the Illinois State Board of Education submits a voucher to the comptroller. The voucher was submitted Monday and the district expects to sell another tranche at a later date.

The district said the $275 million will provide “sufficient cash for the district” to meet its pension payment. It needs to pay about $470 million toward its $733 million teachers’ pension contribution by the end of the month.

“No assurance can be provided by the board as to the timing of any future receipt of block grants from the state,” the financing documents said.

The financing documents note that Illinois currently lacks a legal path to Chapter 9 although Rauner has endorsed such legislation. “If the board were authorized by state law” and it were to “become a debtor in bankruptcy…it is possible that the application of the grants to pay the notes could be stayed during the proceeding,” the financing documents read. CPS leaders and Emanuel oppose such Chapter 9 legislation or a filing “to restructure” outstanding debt.

FUTURE QUESTIONS

The costly short term rate raises questions over whether the district can publicly borrow long-term at a rate under the 9% limit set in state law, several market participants said.

The Board of Education in May approved $215 million of GO refunding bonds that brings to $500 million the amount of authorized fiscal 2018 GO borrowing.

CPS paid a high yield of 8.5% early in 2016 -- with a big discount offered – for a spread on the 2044 maturity at 580 basis points over the top-rated Municipal Market Data benchmark.

CPS later entered into a private placement for $150 million of GO debt in July at a 7.25% rate. Amid rising rates after the November election, it put off a GO sale late in 2016 and returned to borrow using a new credit backed by a freshly levied capital improvement tax. The 2046 maturity paid a yield of 6.25% -- at a discounted price – for a spread of 309 basis points over the MMD’s AAA.

The district has said it will seek board approval to authorize up to $1.55 billion of short term TAN lines in fiscal 2018 – the same as fiscal 2017.

With prospects for more state help in fiscal 2018 clouded, it’s unclear how CPS will close a looming deficit. It whittled down a $1.1 billion gap with cuts last year and received a boost from the $250 million pension tax levy. It needs hundreds of millions to balance next year’s budget.

Emanuel has said he's not ready to show his hand on how the city might help CPS – options include new or increased taxes and fees or tax-increment financing revenue -- if state support falls short.

PFM Financial Advisors, LLC and Columbia Capital Management LLC were financial advisors on the GANs. Katten Muchin Rosenman LLP and Cotillas and Associates were co-bond counsel.

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